For investors looking for a secure place to put their money, a certificate of deposit (CD) is a perfect vehicle. CDs issued by US financial institutions are generally guaranteed up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), so they really are a risk-free investment. However, compared to many other types of investment, the returns on a CD can be quite low – this is the trade-off for minimizing risk. However, just because CDs are a conservative way of protecting cash, this doesn’t mean that investors shouldn’t look to maximize their returns.
To start with, there is actually quite a lot of variability in the rates that different financial institutions offer. It pays to shop around – and especially pay attention to banks who are offering attractive promotional rates to attract customers. The other thing that affects rates is the term of the CD – if you lock in your deposit for a longer time, banks are willing to pay higher interest rates in return. Before you invest in any CD, you should look at the current rates for different maturity periods across a range of institutions – for example, you can find the best 12 month CD rates here.
However, once you have located the best deals, there are still a number of investment strategies that you can use to maximize your return. For instance, let’s look at laddering. One of the downsides of buying a regular CD is that you cannot get your money out until the CD matures – for example, if you buy a two-year CD, your money is locked in for that period of time. On the other hand, you may anticipate that interest rates are going to rise, which is a distinct possibility given the historical lows they are at right now. This leaves a dilemma – should you invest in short-term CDs, which don’t have as good a yield as long-term CDs, in order to make sure your money is available to invest once rates rise? Or should you lock in the higher rate of a three-year CD now and lose the opportunity to benefit from future rate increases?
Laddering allows you to balance both ends of the equation by using a combination of short-term and long-term CDs. For example, assume that you have $30,000 to invest. If you put $10,000 of this into a 12 month CD, another $10,000 into a 2-year CD, and the remaining $10,000 into a 3-year CD, then you will see a higher average return than if you invested the entire $30,000 into a 12 month CD. However, in one year, the 12 month CD will mature, a year later the 2-year CD will mature, and so on. This means that 33% of your money is freed up each year to invest at the then-current interest rate. In fact, if you reinvest that money each year into a 3-year CD, then you will maintain a rolling turnover of CDs, with one third of your capital being released each year.
Another way that may sometimes increase your return in a rising interest rate market is to buy brokered CDs. These are created when a bank or other financial institution issues a large plain-vanilla CD, which is then subdivided by a broker into a number of smaller brokered CDs – which you can purchase. Because there is an intermediary – the broker – in the transaction, the interest rates you will get on a brokered CD are slightly lower than if you were to purchase a CD yourself. However, the advantage is that brokered CDs can be traded on the secondary market – in other words, you do not have to wait for the CD to mature, and can free up your cash at any time to take advantage of a better opportunity. However, you should confirm with your broker that the CD is covered by FDIC insurance – this is normally the case, but there are circumstances where you may not be covered.
Finally, you may want to consider investing in a market-linked CD. These are a relatively new type of investment, where you are guaranteed a return that is similar to a traditional CD, but also offer potential upside since your deposit is invested in blue-chip stocks. If the market goes up, you get an additional return up to a fixed limit – say 6% in a year. The bank is in effect making a bet that the stock market will rise more than that, and will hold onto any profits in excess of the limit. In return for this, they protect you from any market downside.
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